In my September blog post, I covered the concept of “The Number.” It is the amount you need to save during your working years in order to have a comfortable retirement. I showed a simple approach to calculate your retirement savings goal along with some of the major expenses that “The Number” needed to cover.
In this follow-up post, I want to provide some practical advice as to what you do with your Number. Accumulating the money is a big priority, but it’s not the end-game. Once you have accomplished your personal retirement savings goal, you must invest it appropriately. Then you must do some calculated tax planning to help preserve it, and withdraw it in such a way as to help maximize it.
Investing your Number during retirement will look a lot different from in the accumulation phase of your working years. During this season, the investing goal for your retirement savings shifts. The focus becomes inflation protection, income generation, and capital preservation.
So what does that all mean? The first thing it means is that you cannot just invest your number in cash. It sounds safe, but the enemy to cash is inflation. In simple terms, you want your dollar today to buy the equivalent in goods and services tomorrow. You do need to hold some cash. But I would limit it to the equivalent of no more than 24 months of living expenses (more on this below).
Next, you need to hold investments that can help to produce an income stream. Dividend-paying stocks and interest-paying bonds are the top choices. These types of investments will help to produce cash flow in retirement. But they also will help in offsetting the effects of inflation on your retirement savings as well.
Lastly, preserving your Number so that it lasts throughout your retirement is the final piece of the investment puzzle. You will spend down a portion of your savings amount each year along with the investment earnings. The preservation piece is highly dependent upon the type of investments selected. It is also dependent upon the mix or allocation between stocks, bonds, and cash. Always get advice from a trusted advisor such as a Certified Financial Planner or CPA. It is the best choice for the majority of retirees.
Being tax efficient in how you invest and subsequently withdraw your retirement savings can really help to preserve your Number.
One area of tax planning for your investments focuses on what type of account you should use. The gold standard is the ROTH IRA (Individual Retirement Account). This type of account allows you to withdraw your retirement savings including the associated investment earnings tax free. But, you must also have attained the age of 59½ and have held your account for at least five years.
If you don’t have a ROTH IRA, you will use a regular Individual Retirement Account (IRA). For tax planning, a regular IRA will put out ordinary taxable income when you take money out of it. These type of accounts are best for holding investments. These investments include bonds, certain dividend paying stocks, real estate investment trusts (REITs), certificates of deposit (CDs), and other ordinary income producing investments.
For retirement savings held in brokerage accounts that are not IRAs or other tax-deferred accounts, the best tax strategy is to use these accounts to invest in stocks and other securities that will be held for a year or more. The result will be to help lower your overall tax bill by utilizing the more favorable capital gains tax rates.
Finally, a proven tax savings approach is to take distributions from each type of account on a proportional basis. You can just calculate what percent of your total Number each account holds. Then take that percent of the total cash-flow you need each year to live on as a distribution from each respective account. This “spreading” method generally can help lower your annual tax bill on retirement disbursements.
A large part of the withdrawal strategy for maximizing your Number in retirement is based on the timing of the distributions with other types of income you might have during those years.
One of the most impactful timing strategies involves planning IRA withdrawals around your social security benefits. Basically, those benefits can be taxable if your overall income reaches a certain level based on your individual tax filing status.
For example, you might consider delaying your social security for a few years up to age 70. This will allow you to take other retirement savings out without any additional tax on your benefits. It also comes with the added bonus of increasing your monthly social security payments by 8% for every year you delay.
This withdrawal strategy also works well in planning for RMDs. Basically what that means is IRAs have a built-in time clock for mandatory withdrawls called a Required Minimum Distribution (RMD). These distributions must start by age 72. Their amount is determined by an IRS calculation based on the value of your IRA account and your life expectancy.
If you reduce the value of your IRA by taking distributions before the RMD timeline begins, then your required amount that you have to take out in the future will go down. That can really help diminish the tax issue related to your social security payments.
One last withdrawal strategy is to try to keep 12 to 24 months of current living expenses in cash that is replenished during positive stock market cycles. The goal here is to harvest your gains in good markets. You don’t want to end end up having to sell in down markets in order to generate cash to live on.
Managing your Number, your hard earned nest egg, during retirement is as important as the work you did in accumulating it. A well-planned investing, tax planning, and withdrawal strategy can help to ensure that your retirement is set on a firm financial foundation!
To learn more about the various business degrees offered at the West Texas A&M University Paul and Virginia Engler College of Business, click here.
David W Clark, MPA, CPA
Instructor of Accounting & Healthcare Management
West Texas A&M University